A fragile currency, plunging returns on mining stocks, and fears of a downgrade to ‘junk’ status, provided plenty to discuss when Funds Europe visited South Africa. Chaired by George Mitton and Alan Chalmers in Cape Town.
Funds Europe: What is your outlook for South Africa in equities in the year ahead?
Thabo Khojane, managing director for Africa, Investec Asset Management: South African equities have come under pressure over the last two years. We had a good run post the crisis – 2012 and 2013, in particular, had strong market performance – and in 2014, our market was up about 11%. But last year, our market was flat in real terms. The pressure’s been there for some time, and I’m afraid it’s going to continue. We will continue to see earnings disappointment, particularly in the mining sector, where earnings were down 40% last year.
That’s a broad picture. Within that, parts of the market will do well, particularly rand-hedged cyclical stocks. We like the media group Naspers, where we think earnings revisions will continue to be positive. We like Old Mutual. We like Steinhoff, which is effectively a European furniture distributor with a rand cost base. We’ve begun to build a position in Sappi, the paper company. The common theme between those stocks is positive earnings revisions.
We also think Vodacom, the telecoms firm, will continue to win market share, particularly in data. And we like Tiger Brands [a packaged goods firm], which underperformed in the recent past but is beginning to do the right things. Broadly, the market is on a high forward price-to-earnings ratio so we think returns will be disappointing but, within that, there are opportunities for long-term investors to make money.
Tamryn Lamb, head of Orbis client servicing, Allan Gray: For the past few years we have been relatively conservatively positioned, and have been cautioning that there was little absolute value in the market, with many companies trading at full valuations. Like Investec, we have favoured defensive, globally diversified rand-hedged stocks, such as beer company SABMiller and British American Tobacco.
However, while the South African market continued to increase in rand terms in 2015, when you dig a bit deeper, you find that it has been an extremely narrow market. In 2015, if you exclude Naspers and SABMiller, the broad market fell approximately 10%, with certain sectors like resources falling over 40% over the period. This is even more stark if you restate these returns to dollars. In dollar terms, the index is at the same level as it was roughly ten years ago.
So, for the first time in a number of years, we are more optimistic on the value inherent in some of the local names than we have been before. In particular, we are finding good value in selected commodity and financial companies. In some of our multi-asset class portfolios, we’ve been gradually increasing our net equity exposure at the margin. We would still characterise our portfolios as conservatively positioned overall.
In terms of specific names, we have a significant exposure to Sasol, the oil and gas and chemicals company, which has underperformed significantly, given its exposure to oil. Other top-ten holdings include Old Mutual and Standard Bank.
Funds Europe: Ratings agencies recently downgraded South African government bonds. How should bond investors respond to this move, and what are the implications for the rand?
Khojane: The short-term factor is the extent to which the budget, is a credible budget that demonstrates a commitment to fiscal consolidation. [Note: this discussion was held before the February 24 budget.] Our view is there’s a good chance that finance minister Pravin Gordhan will produce a good budget. But that’s short-term. The longer-term issue for South Africa is whether we can overcome structural obstacles to growth, whether they be labour flexibility, productivity, the reliability of power supply, the cost of doing business generally, the quality of infrastructure, or regulatory burdens where they exist. Those are the real issues, and we need to see signals that our government is serious about tackling them.
There is also the National Development Plan, which we are all behind. Hopefully, we will see a resurfacing of some of the principles contained in that plan. If we see all that, as a bondholder and as a rand-based investor, we’ll become more optimistic, but it’s early days.
Lamb: Yields have already spiked over the past year, for obvious and well-known reasons, and are trading at the top end of their 12-year trading range. The departure of Nhlanhla Nene as finance minister and then Pravin Gordhan coming back in surprised the markets, equity and bond alike. Foreign buyers own approximately 30% of the government debt, so foreign investor sentiment is important.
Yields on the ten-year government bond are now approximately 10%. Assuming long-term inflation expectations of between 6% and 7%, this would imply a real yield of about 3%. We are incrementally more bullish on bonds than before. However, we have kept a low duration in our bond portfolios, relative to the index. We prefer either the shorter end of the curve or the middle, because the extra pick-up in yield you get for the longer-duration bonds doesn’t seem to compensate for the risk.
There remains uncertainty about the government’s approach to fiscal restraint, and whether they will be able to implement effectively on plans to cut spending. There have been constructive discussions with business over the past couple
of weeks, but if these are reversed, and the government proves ineffective at cutting spending, you could see yields spike even further.
On the ratings downgrade, it is on many people’s minds at the moment. It’s hard to know what the exact impact of a downgrade will be on yields, because some of the effects could already be priced in, but, certainly, a downgrade would put further downward pressure on prices and increase borrowing costs. It would have a negative impact on the rand, but on the flipside could cause a reassessment and could possibly encourage further fiscal restraint.
Khojane: I would add that one of the positives about where the country is today versus, say, ten years ago, is that there’s a lot we can do without spending. The governance of our state-owned enterprises could be significantly improved, and that won’t cost a cent. If we could remove regulatory uncertainty, or reduce it, it won’t cost us a cent either. There is some low-hanging fruit that could have a massive impact.
Funds Europe: What types of investment products have been most in demand among your clients in 2015 and which do you predict will be popular in 2016?
Lamb: It’s not surprising that the biggest demand has come for offshore products, which typically happens when the rand is deteriorating. There is a difficulty, though. Many managers – Investec and Allan Gray included – create rand-denominated vehicles that utilise our unit trust management company capacity to invest directly offshore.
For Allan Gray, we’ve reached our capacity and we have had to close those rand-denominated foreign funds to new flows.
Multi-asset class mandates have also been consistently popular, both balanced and stable. I don’t know whether people are uncertain and want to entrust the asset allocation decisions to a manager or if it’s because they are trying to take risk off the table.
Khojane: Offshore will be the big winner. It will continue on the back of the weak rand as well as uncertainty about where we’re going as a nation. Multi-asset, as a category, has been a big winner of flows for the last decade. I would say that’s driven by a combination of investors and advisers lacking confidence about their ability to asset allocate and, also, good work on the part of multi-asset managers.
If you look at the leading multi-asset managers in South Africa – Allan Gray, Coronation, Prudential, Investec – they have had persistent performance over the past 20 years. It’s not difficult to pick a good multi-asset fund in South Africa.
If you look at the last five years, multi-asset funds have won about 75% of flows, and if you look at the current assets under management in the industry, something like 60%-65% of assets are in the multi-asset space. Will that change in future? Perhaps the rise of the retail investment consultant or discretionary fund manager (DFM) will have an impact. The DFM has to, at some point, demonstrate their reason for existence, and it’s hard to do so if you’re simply allocating between four multi-asset funds. I expect that, at some point, the DFM will begin to argue that there are some efficiencies to be gained from a specialist manager structure, some cost reductions, removal of overlap in the portfolio, and so on. My expectation is that the 75% of flows going to multi-asset funds will decline in future.
Funds Europe: How are you preparing for the South African retail distribution review (RDR), expected to come into force in 2016? What effects will this legislation have?
Khojane: RDR is a positive development. It’s a move towards greater transparency, unbundling of fees so that the end client knows what they’re buying and what they’re paying for it. Because the UK led the way on this, and we have a large UK business, we began to think about the RDR long before the draft regulations were issued in South Africa. In 2008, for example, we began to move away from rebates. Two years ago, both our platform business and our unit trust business introduced clean fees. In a sense, we have moved ahead of regulation, because we’re positive about the principles that underpin it.
Lamb: There is still a lot of uncertainty as to how and in what form the RDR will get implemented, if it does get implemented in 2016, but I would echo the same sentiments. The underlying principles are ones that we think, as a business, we’ve held true to – transparency, ensuring fees are fair, segregation of the value chain, independent advice. We feel we are prepared for the regulations.
RDR might have an impact on the advice industry. In the UK, there has been a lot of consolidation post-RDR and a shift back to tied advisers, rather than IFAs [independent financial advisers]. This could be because there is more regulation that the smaller boutique IFA practices need to navigate. What the effect might be, for both Investec and Allan Gray for example, could be more in the second-order impacts as a result of what happens to the advice industry.
Khojane: On that point, we think one of two things could happen. One is that the smart advice businesses will find a scalable way to advise the slightly less wealthy, perhaps by embracing technology and seeing robo-advice not as an enemy but, potentially, a tool. We might also see some of the product providers coming up with products that are targeted towards those who can’t afford advice or who are not attractive to advisers.
Funds Europe: What is the best way to develop a pan-African strategy? Which are the key African markets to target and how can you deploy resources most effectively?
Lamb: A number of South African businesses have tried and failed and a handful have succeeded. We believe you have to take a long-term approach and be cautious of trying to build up a big presence in a short amount of time, by either acquiring where you may not be the knowledgeable buyer or by spending heavily in a market you don’t fully understand.
At Allan Gray, we’ve taken a conservative approach. We looked at a number of markets and eventually settled on the two primary markets being Nigeria and Kenya. In both instances, while it’s important to have somebody who’s a seasoned professional from within the business, it’s also important to have local knowledge, so we set up two small offices. Nigeria has been going for a few years and Kenya is in the process of being launched and we’ll have people on the ground shortly.
Why those markets? A number of factors resulted in those markets being chosen, but among other factors we looked at the size of the market and the regulatory environment.
Another point is that, where a market is underbanked and savings penetration is quite low, perhaps the traditional model of reaching clients might not work. Technology such as the M-Pesa mobile money service from Safaricom in Kenya is a good example of how accessible technology can play a role in accelerating the uptake of certain services.
Khojane: We think about the rest of the continent in a couple of ways. The first is as an investor. Despite the fact that we’re African-rooted and we grew up in Cape Town, today we are one-third African in terms of clients and two-thirds non-African. So, as an investor, looking at the rest of the continent, we’re trying to access opportunities for our European, American, Asian and Middle Eastern clients. From that perspective, we remain bullish about the long-term prospects for Africa, in particular East Africa.
As an investor, we’ve developed a public equity capability, but we found that some of the best opportunities are not in the public markets. They’re in the private markets. That’s why we have launched our second private equity fund and are in the process of launching a real estate capability, which will be hopefully followed by an infrastructure capability. The long-term themes that excited us about the African continent in 2004 are largely still there – the rise of the consumer, financial deepening, infrastructure development and growing penetration of mobile telephony. Those four themes, for us, are
We also think about the rest of the continent as an opportunity to serve the savers in some of those markets. We are beginning to see reasonable domestic savings pools, particularly in Kenya and Nigeria, however our medium-term strategy is not to target domestic savings. Our medium-term strategy is to target institutions and specifically their offshore exposure, whether it be large government pension funds, sovereign wealth funds or central banks. From that perspective, we’re quite excited.
In Botswana and Namibia, we’ve been operational since 1996, and we’ve now expanded into east and west Africa as potential opportunities for us.
Funds Europe: What is the best way for South African asset managers to reach potential clients in Europe, Asia and elsewhere? Are Ucits funds still the main vehicle? And what are the main challenges you face as you seek to build a global brand?
Khojane: We began globalising our business 20 years ago. Today, if you look at our client base, we operate on six continents. We’re about 70% institutional and 30% retail. For the retail part of our business, we have a Ucits range domiciled in Luxembourg. For the institutions, we set up bespoke, segregated portfolios.
Lamb: Our founder, Allan Gray, left South Africa in 1989 and started Orbis, Allan Gray’s offshore sister company. The firms have the same majority owner but are run as independent businesses. Allan Gray is focused on South Africa and Africa, and Orbis runs global equity and multi-asset class mandates. Our clients’ offshore investments are placed with Orbis, which runs about $25 billion.
One thing we believe is that it’s difficult for a South African asset management business to successfully internationalise unless they build a sustainable, on-the-ground presence overseas. If you are a UK pension fund, you want to be invested with someone who you believe is local, who has developed and demonstrated a long-term commitment to your market. Regarding fund types, Ucits is definitely the main vehicle. We also have a range of Bermuda funds, and Orbis also has a big presence in Bermuda.
Khojane: Our experience is that, if you are targeting a European investor or an Asian investor, the first conversation should not necessarily be about Africa, even though you’re African-rooted. You shouldn’t box yourself as only an African manager. So our first conversations, typically, are about global equities. The second conversation will be about emerging market debt. The third conversation will be about global balanced and maybe the fourth or fifth conversation will be about African equities. By then, there’s no risk that you box yourself as just an African manager.
Funds Europe: Are you optimistic or pessimistic about the funds industry in South Africa in the coming 12 months, and why?
Khojane: Over the next year or two, despite the fact that returns will be well below what the market is used to, retail savings flows and the growth of the industry will continue to be healthy. We estimate that, in 2015, net flows into the mutual fund industry in South Africa were about 40 billion rand. Previous years were 70-100 billion rand, but that was understandable given that the equity market was giving 20%-30% returns. Even with returns disappointing, there is a structural underpin to flows that remains in place, and that is the defined contribution pension schemes.
If I look ten or 20 years into the future, the kicker for the South African retail savings pool will be retirement fund reform, in particular, compulsory preservation. That’s going to be absolutely key. Politically, it will be tough to get it over the line, but it will happen. The president signed into law a tax law that, effectively, was about compulsory annuitisation. He’s been challenged and already he’s beginning to have second thoughts. We will see a lot of that – a lot of two steps forward, one step back – but there’s no doubt we’re going in the right direction.
When preservation and annuitisation kick in, the 10% annual growth of the retail savings pool that we’ve seen over the last decade will go to levels more like Australia, where it’s 20%-30% growth a year. That means the underpin for the retail savings pool in South Africa is strong and, if I was starting a business today, a global business, and I had to pick where I wanted to play, South Africa would be on my radar. We’re a small market in global terms, but there are positive developments in the pipeline.
Lamb: We think, first and foremost, about the returns we can deliver for clients and, while we know that absolute returns may be disappointing for clients, relative to what they’ve seen in previous years, we’re seeing increased opportunities across the market.
The lack of compulsory preservation in the system today is a problem, and the government appears to have recognised that. Many pension schemes are faced with member disinvestments when employees resign or are retrenched, because people are not keeping their money within the system. The introduction of products like the tax-free savings account could help individuals to gain a foothold into the savings market, which is underpenetrated from a mass-market perspective.
The long-term trends are going in the right direction, but there is still uncertainty around how they will be implemented.
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